How was Christmas for consumers and retailers?

UK consumers did not have a good Christmas and, since consumption is the main component of aggregate demand, this is a serious problem for the UK economy and for retailers in particular who rely on high spending at Christmas. Furthermore, not only was consumption lower than hoped for by retailers, it has also been financed by significant increases in household borrowing (see Mr Dean’s recent post). According to the British Retail Consortium, the retail sector experienced their worst Christmas since the financial crisis in 2008 with sales which were basically the same as last year. They reported that, although spending on groceries was higher than last year, spending on other categories such as clothing, were lower. Barclaycard confirmed this when they reported a real terms fall in consumption in December of 0.5%

There are a number of possible causes for low consumption. In the past, we would have looked at what has happened to consumers’ real income. However after many years of falling real incomes, last year incomes started to increase at a faster rate than inflation so this is no longer a factor. More likely is a fall in consumer confidence as doubts about the future of the UK economy increase as progress towards Brexit falters. There have also been declining car sales with new car registrations falling 6% in 2018 compared to 2017 caused by Brexit uncertainty and a fall in the attractiveness of diesel cars. There has also been a fall in spending on recreation and travel. Not only have foreign holidays become more expensive as sterling has dropped in value, consumers have cut back on meals out, recreational activities and travel.

But possibly not all is not doom and gloom. Part of the reason for the fall in December spending was people buying more in November to take advantage of ‘Black Friday’ offers. However this was not good news for retailers in the high street since many of the ‘Black Friday’ purchases were on line. This might mean that there will be more stores following Maplin, Toys R Us, Carpetright, HMV, Poundworld and House of Fraser.

UK household debt reaches peak

www.bbc.co.uk/news/business-46780279

Article of the week – Harjot M.

High levels of household debt pose a risk to the economy because any increase in interest rates could lead to a sudden collapse in consumption. Higher borrowing costs mean households have less discretionary income resulting in a fall in consumer spending. Aware of this risk, firms may consider cutting investment in the expectation of a fall in future demand. Consequently, aggregate demand decreases causing a fall in inflationary pressures, a decrease in economic growth and, potentially, an increase in demand-deficient unemployment.

Is the next financial crisis round the corner?

It is now 10 years since the financial crisis and concern is beginning to be expressed that we could be heading for another in the near future. If it does occur, how well-placed is the UK to withstand it?

The IMF recently examined the finances of 32 countries, comparing what governments owe, e.g. pension liabilities and national debt, with what they own, e.g. land, buildings and natural resources, and concluded that, by this measure, the UK has a net liability of more than £2 trillion – over 100% of GDP. This is not the usual way of looking at a government’s indebtedness, which compares government debt to GDP, but, for example, it does highlight the difference between Norway and the UK in terms of making use of the revenues received from North Sea oil. Norway used them to build up a large stock of financial assets, currently worth over $1 trillion, or almost $200,000 per person which has generated income, while the UK used its North Sea oil revenue for current consumption and tax cuts.

Just as the IMF was undertaking its analysis, the Financial Policy Committee of the Bank of England warned of excessive world-wide lending by banks to businesses and the danger that banks are relaxing their lending standards, particularly in the US, and compared the current situation to the approach to the 2008 crisis. However, a big difference between now and 10 years ago is that commercial banks’ capital reserve rations have increased, and they are now more closely monitored with regular stress tests which examine the way different scenarios, such as rising inflation or unemployment, will affect banks’ ability to withstand shocks. The results of UK stress tests will be published in December.

Worryingly, it is not only business borrowing which is an issue. UK household debt has also increased dramatically. The ONS suggests, not surprisingly, that it is the poorest families who are most in debt. Their analysis showed that, in the 2016/17 financial year, the lowest 10% of households spent two and a half times their disposable income   while the richest 10% spent less than half of their disposable income.

A National Audit Office report in September suggested that average UK household debt (including mortgages) was £58,540 in June, and, overall, people owed nearly £1.6 trillion at the end of June 2018, up from £1.55 trillion a year ago. British households are now among the most indebted in major western countries, with credit card debt and payday loans climbing to record highs. Another source of debt which is potentially worrying is car finance where PCPs (personal credit plans), which allow one to buy a new car with a very small deposit but pay for it over three to four years, are becoming popular.

A key question which worries the Bank of England is what will happen to debt if interest rates continue to rise. Will zombie businesses and poorer households be able to afford higher interest payments or will they, like the sub-prime mortgage borrowers of the last decade, end up defaulting on their loans? On the positive side, wages are growing at their fastest rate since the financial crisis, up 3.2% in the three months to September, but faster wage growth, indicating that the labour market is finally tightening  in response to record low levels of unemployment, might encourage the Bank of England to raise interest rates sooner than they otherwise would have done, possibly hastening a crisis.

UK Consumer Spending

Consumer spending is a major component of GDP and, to assist in its analysis, the Office for National Statistics has just produced an analysis of spending within regions across the UK. The data was collected using two surveys –  the Living Costs and Food Survey (also used as the basis of the Consumer Price Index) and the Annual Business Survey which records sales of businesses. The former looks at 5,000 households (not a particularly large number when broken down into regions) which are interviewed and keep a diary of their expenditure for a two-week period; the latter records retail sales of 80,000 businesses, so provides a larger sample, but suffers in accuracy because some sales go to businesses, not consumers.

The data is broken down into twelve categories which are in turn subdivided into narrower classifications. The twelve categories are food and soft drinks, alcohol and tobacco (and narcotics), clothing and footwear, household goods and services, housing, health, transport, communications, recreation and culture, education, restaurants and hotels, and a miscellaneous category covering items not included in previous sections. The data is also split down into nine English regions, Scotland, Northern Ireland and Wales.

The average spending per person in 2016 in the UK was £18,787 and, not surprisingly because of high incomes and high housing costs, London had the highest national expenditure (£24,545), while the lowest spending was in the West Midlands (£15,276) and Wales (£15,965). The region with the highest growth between 2015 and 2016 was the North East (8.1%) while the lowest growth was in Northern Ireland (- 0.4%), the only area to see a fall in spending per person in this period.

The survey also provided information about the levels of savings across the country with an average savings ratio (savings out of disposable income) of 6.9%. The ratio was highest in London (14.5%) while the lowest levels occurred in the South West, (1.5%).

The ONS looked at the breakdown of spending between the different categories. London stood out, with 42% of spending going on housing, compared to the UK average of 27%. As a result, it spent proportionately less in the other categories. Excluding London, there is relatively little variation between the regions although, proportionately, spending on tobacco in Northern Ireland is high, spending on food and clothing in Yorkshire is lower than in other regions and spending on recreation and culture in London is the lowest of all areas. The UK averages were: Food 10%, Alcohol and tobacco 4%; Clothing and footwear 5%; Housing 27%; Household goods and services 5%; Health 2%; Transport 13%; Communications 2%; Recreation and culture 10%; Education 1%; Restaurants and hotels 10%; Miscellaneous 13%.

Since 2014, among the sub-categories are drugs and prostitution and their inclusion has added about £10billion to the UK’s GDP. However, because these activities are traded in the shadow or hidden economy and the suppliers do not disclose their earnings to the tax authorities, the ONS has warned that the accuracy of these two categories is low. Nevertheless, it was still able to suggest that more is spent on prostitution than on gardening and DIY activities.

Falling Share Prices – Causes and Effects

This week has seen major falls in share prices across the world with $6 trillion being wiped off world share values.  America’s Dow Jones index dropped 5.2%, Japan’s Nikkei index fell 8.1% and the UK’s FTSE index fell 4.7%, the lowest it has been for 15 months, while in Japan and America the falls broke records for the size of their drop since October 2008.

The initial reason for the fall was, paradoxically, good US economic data as their service sector boomed and wage levels grew at the fastest rate since the start of the decade. This good news meant that it is now more likely that US interest rates will rise sooner and by more than had previously been anticipated. Mark Carney reinforced this view when he expressed similar sentiments about the future of UK interest rates.

Although a rise in interest rates has been expected for some time as the world economy’s growth accelerated, the reminder that it might occur soon has come as an unpleasant shock. The scaling back of QE by central banks is expected to reduce the ability to borrow cheaply, some of which has financed recent purchases in shares. Financial investors expect that the forthcoming rise in interest rates will reduce company profits, therefore reducing the demand for shares. Simultaneously existing shareholders might be encouraged to sell quickly before prices fall further, thereby increasing the excess demand. In addition, the economic uncertainty was increased by the fall in the value of bitcoin by approximately 50% since the state of the year.

Economists are trying to decide whether we are currently experiencing a “correction” or  are entering a bear market, where prices fall by more than 20%. The “correction” proponents believe that shares are over-priced in terms of their price compared to their earnings – the price:earnings ratio – and therefore the fall was due. However there is concern that the behaviour of investors, whether in shares, currencies or commodities, sometimes leads to markets over-shooting since falls (increases) in price encourage selling (buying) which further reduces (increases) the price.

According to economic theory, the fall in share prices might lead to a negative wealth effect (the idea that consumption is determined by one’s wealth as well as one’s income). However, given that many shareholders are in the upper income brackets, their marginal propensity to consume will be low and therefore the effect will small. More significant might be the general impact on consumer and business confidence from the media reports about the falling share prices. As Keynes wrote in his General Theory,  “animal spirits” outweigh the  “weighted average of quantitative benefits multiplied by quantitative probabilities.”.

So how is the economy doing?

This week has seen the publication of considerable economic data and much of it is contradictory, making it hard to tell exactly how well the UK economy is (or is not) doing.

In the year to March 2017, household spending in real terms returned to levels not seen since before the financial crisis, reaching £554 per week. The UK budget deficit has fallen and was £2.6bn in December, compared with £5.1bn in December 2016, and almost half economists’ expectations. This was partly due to higher than expected tax revenues from income tax receipts because of higher employment, higher VAT receipts and a refund on contributions to the EU. The positive news on the budget deficit means that government borrowing is likely to be at its lowest level since the financial crisis. Before celebrating too much, be aware, firstly, that the higher VAT receipts were due to higher inflation as well as to the growth in consumption and, secondly,  the refund from the EU was because the UK share of the EU budget has been revised downwards as a result of slower growth in the UK than the rest of the EU.

Another boost for the UK economy  was news that the employment rate had risen to a record high of 75.3% or 32.2 million, confounding forecasters who had predicted that the employment boom was over, based on the fall in October 2017 which is now being treated as a temporary fluctuation. At the same time as the employment level rose, the unemployment rate remained at 4.3% or 1.4 million, a 42-year record low. Equally encouraging was the shift from part-time work to full-time work which occurred over the period.

Further positive news  was that the economy grew at 0.5% in the last three months of 2017, faster than expected, largely because of the resilient service sector which makes up about 80% of the economy. As a result, growth last year was 1.8%, significantly higher than the 0.5% prediction by some disappointed economists following the Brexit vote. However, it is worth noting that the UK has dropped from being a growth leader to a laggard among the G7 countries, its growth rate is now at its lowest rate for the last five years and, given more rapidly rising incomes among our main trading partners, a slowdown in UK growth is disappointing.

On the downside, wage growth continues to be slow, meaning that real incomes are falling, the number of people starting apprenticeships fell by a quarter in the three months between August and October compared to last year, and sterling rose to its highest level since the Brexit vote. While this is good for importing businesses and holiday makers, it is less good news for exporters who have enjoyed the benefits of a low pound. It has also hit the share prices of companies with significant dollar earnings which are now worth less when converted into sterling.

Finally a word of caution; some of the figures, such as consumption spending, relate to the previous financial year while others, such as the growth in GDP, are subject to significant revision over time. Most recently, the figures for UK productivity have been questioned because the ONS might have significantly over-estimated inflation in the telecommunications industry and therefore underestimated the increases in its output. As a former Governor of the Bank of England pointed out, “trying to control the economy is like steering a car by looking in the rear view mirror”.

What’s in store for the UK economy in 2018?

Santa has been and gone, the sleigh is parked in the long-stay car park, the reindeer are out to graze for a few months and it is time to think about what 2018 will have in store for the UK.

However economic forecasting is difficult. Unlike the natural sciences, such as physics and chemistry, we cannot base our predictions on previous laboratory experiments. Furthermore, although economists frequently assume “ceteris paribus”, the real world is not like this. For example, we do not know what the outcome of the Brexit negotiations will be, whether the bitcoin bubble will burst, and, if it does, what the impact will be, whether there will be a new Prime minster  or a general election this year or even what will happen to oil prices.

In an article published in the last week of 2017, The Times examined predictions made by key economic bodies (the Bank of England, the CBI, the Office for Budget Responsibility, the Institute of Financial Studies and the British Chambers of Commerce) a year ago for the economy in 2017. As the table below indicates, the results are not encouraging.

	Growth	Inflation	Unemploy-ment	Wage Increase	House-hold Spending Increase
End 2016 Figure	1.9%	0.7%	4.9%	2.8%	2.8%
Highest prediction for 2017	1.6%	2.7%	5.4%	2.75%	1.5%
Lowest prediction for 2017	1.1%	2.1%	5.1%	2.1%	0.6%
Actual figure for 2017 (latest estimate)	1.7%	3.1%	4.3%	2.5%	1.0%

 

The UK’s growth performance has dropped from first place among the G7 in 2016 to close to the bottom and, in addition to the data above, we should note that share prices in the USA and the UK are at record highs, as is employment in the UK. However particularly worrying is the fall in real incomes which has impacted on consumption growth.   UK productivity growth has been low, with businesses tending to increase labour rather than spending on capital. Although the very latest figures show an improvement, this is because hours worked have dropped rather than output increasing. In addition, house price growth, particularly in London, has slowed.

In thinking about what might happen to the UK in 2018, there is the old saying that “when America sneezes, the world catches a cold”. This is still applicable but we might include China since the performance of the world’s largest economies will have both direct and indirect effects on the UK, since their faster growth will directly impact on our export sales and indirectly as rapidly growing demand for raw materials overseas pushes up prices for UK firms and consumers. On the other hand, we do not know whether President Trump’s desire to implement policies  focussing on “putting America first”, will have an impact on the rest of the world.

The IMF is positive about the prospects for the world economy in 2018. It predicts that world GDP will grow by 3.7% and this recovery is likely to continue for a further four years. This faster growth is the result of the three main economic areas (North America, Asia and Europe) all recovering rapidly at the same time. Businesses in the USA and France are confident following the election of business-friendly Presidents Trump and Macron, and this confidence should have a positive impact on investment. In addition, even though there have been interest rate rises in the USA and the UK, the level of world interest rates and the positive effects of QE continue to facilitate growth. The IMF therefore expects that average unemployment in the G7 will drop below 5% this year for the first time since the 1970s while inflation will remain below 2%.

Time to feel sorry for economic forecasters.

 

 

The end of the era of low interest rates?

On Thursday 2^nd November, the Bank of England increased interest rates. Although the increase was not large (from 0.25% to 0.5%), possibly it marks the end of an era. It was the first increase since 2007 and follows the cut in rates in 2009 from 4.5% to 0.5% after the collapse of Lehman Brothers. The rate was further cut in 2016 to 0.5% following the Brexit vote.

Traditionally the rate rise should benefit savers and make it more expensive for borrowers, particularly those with mortgages. However the UK economy has changed in the ten years since rates were last increased. Banks have been far slower to reward savers  than to punish borrowers when rates rise so savers should not get too excited by the rise in interest rates. More importantly, the number of homeowners with variable rate mortgages has fallen significantly, with The Times estimating that only 10% of households will be affected by the rate rise. This is partly because of the shift to fixed rate mortgages, which now account for 60% of mortgages, the increase in renting and the repayment of mortgages among older households.

Secondly, although in percentage terms the rise is large, in absolute terms it is relatively small and, for a family with a £250,000 variable rate mortgage, they will currently be paying approximately £1,125 per month and their payments will rise about 2.25% or £25 per month. This will reduce discretionary income and consequently consumption is likely to be slightly reduced. There are however two more significant effects. Those borrowing via  credit cards or taking out loans for large purchases such as cars or furniture, will see borrowing costs rise and this could deter future consumption. Another issue is that people currently with very high borrowing, particularly those on low incomes, might find it increasingly difficult to repay the interest on their existing borrowing, with an impact on bankruptcies. Most important is likely to be the psychological impact of the rate increase since a signal has been sent out that the era of ultra-low interest rates is coming to an end.

The rate increase is not unexpected, having been forecast in the press for some time. The recent rise in inflation to 3% made it more likely. However it is worth assessing the decision  in more detail. Normally interest rates increase as inflation rises in order to reduce inflationary pressures in the economy and keep inflation within the 1% – 3% band set for the Bank of England by the Government. According to the traditional Phillips Curve idea, rises in inflation are likely to occur simultaneously with falls in unemployment as increases in aggregate demand in an economy work simultaneously to increase prices and reduce unemployment as firms attempt to hire more workers to increase output, thereby putting an upward pressure on wages which then feeds into higher inflation. One could therefore easily argue that, at many times, an increase in interest rates is a sign of a strong economy experiencing rapid growth.

The current situation is slightly different. The increase in UK inflation can be partly explained by the fall in the value of sterling following the Brexit vote and this will drop out of the CPI index over the next few months. Secondly, although unemployment is at a record low at 4.3%, there has not been the rise in earnings which, in the past, we would have expected to accompany the strength of the labour market, thirdly there has been a slow-down in the UK’s rate of growth and finally there is still considerable uncertainty in the economy about the outcome of the Brexit negotiations which is affecting confidence among businesses. So why the rise in rates?

One explanation for the rise in interest rates comes from Ed Conway, the Economics Editor of Sky News who suggests that the UK’s ability to grow without inflation has fallen in recent years because of our poor productivity growth. Whereas in the past we might have been able to sustain growth of 2 – 2.5% without inflation, he thinks the maximum figure for non-inflationary growth might now be 1.5%. Therefore, without compensating action, inflation is likely to increase.

 

What’s going on in the UK economy?

Trying to understand what is going on in an economy can be difficult. Running the economy has been described as similar to trying to drive a car while only being able to look in the rear-view mirror. You know where you have been but cannot see what is ahead. Economic forecasters today probably look back to the period before the financial crash when the UK was in the NICE decade (non-inflationary, continuous expansion) as a golden period. Today life is more complex and one cannot help but feel sorry for the Chancellor busy preparing his November budget and the Monetary Policy Committee of the Bank of England when they meet in November and have to decide whether to increase interest rates.

On the one hand, implying  a rate rise is not yet needed, the Office for National Statistics has just announced that GDP growth has fallen from 1.8% for the first quarter of 2017 to 1.5% for the period April to June which is below expectations and the weakest figure for four years. This is partly down to a fall in services of 0.2% which comprise 80% of GDP inflation. Furthermore discretionary income (what you have left to spend after tax and spending on essential items such as food, energy and transport, has fallen and 60% of households are worse off than they were a year ago as a result of wages rising at 2.1% while inflation is currently 2.9%. Another piece of evidence is that a survey published over the weekend by the Nationwide  reported that house prices dropped in London by 0.6% between July and September compared with the same period last year. This is the first such fall for eight years. 

However the high rate of inflation combined with the fall in unemployment  to 4.3% would suggest it is now time  to reduce the level of aggregate demand by raising interest rates.

Just to make the whole picture more confusing , there is the danger of depressing demand at a time when the economy is fragile because of uncertainty regarding Brexit and one does not want to do anything to discourage business investment which is supposed to be weak because of low confidence. Yet business investment actually rose by 0.5% in the second quarter of 2017! Furthermore, although the current account deficit rose to £23.2bn in the second quarter from £22.3bn in the first quarter, exports of goods and services actually rose by 1.7% while imports increased by 0.4%. Finally, just when you might think you have taken account of all the main variables – what about oil prices which have a significant impact on inflation and discretionary income. OPEC’s decision to curb production is intended to keep prices high and, although this looked to be failing earlier in the year, the combination of hurricanes damaging US oil refineries and the OPEC production curbs have started to have an effect on fuel prices.

 

Good news for the Chancellor?

Friday’s papers contained news which might make life easier for the Chancellor when he prepares for his budget on 22^nd November. Government borrowing in August fell faster than expected, meaning that the Chancellor will have approximately £10bn more to spend on helping reduce student debt, boosting public sector salaries, spending on the NHS, improving our infrastructure, etc. At £5.7bn, the Government’s August deficit has fallen to its lowest level for a decade. The reason for the fall is twofold. VAT receipts have soared because of  high consumer spending while current government spending, particularly local authority spending, has fallen.

However all is not rosy. Firstly, when interest rates rise, which is likely to happen sooner rather than later, government debt interest payments will increase, as will interest paid on index-linked borrowing because of higher inflation rates (borrowing where the rate of interest is linked to the rate of inflation). Furthermore, there are certain commitments which have already been made, particularly with regard to public sector pay, which will necessitate higher government spending. If these factors are not to increase government borrowing then either taxes will  increase, other areas of government spending fall or the UK economy must grow sufficiently strongly to generate enough extra tax revenue.

Secondly Moody’s, one of the major ratings agencies, last week downgraded the UK’s credit rating from Aa1 (the top rating, sometimes referred to as triple A) to Aa2 on the grounds that leaving the European Union was creating economic uncertainty at a time when the UK’s debt reduction plans were in danger because of the decision to raise spending in certain areas. This follows a downgrading in 2016 by the other major agencies, Fitch and S&P. The downgrade might affect how much it will cost the government to borrow money, particularly on foreign financial markets. The Labour Party has called the downgrade a “hammer blow” to the economic credibility of the Conservatives.

Thirdly the stronger than expected level of consumer spending which boosted VAT receipts is unlikely to be sustainable as real incomes fall because of the low levels of wage increases combined with the higher levels of inflation. The forecast for the growth in retail sales compared to a year ago was 1.1% whereas the actual number was 2.4%, with last month showing particularly strong growth. There are many possible reasons for this. Possibly the weak pound caused more people stayed at home instead of going overseas for a holiday, possibly the falling unemployment had an effect and possibly the figures will reverse next month since they are extremely volatile.

Finally it is worth noting that the OECD (the Organisation for Economic Co-operation and Development, an organisation comprising the world’s major economies) forecasts that we will fall from being the second fastest growing  G7 economy to the second slowest as the other main economies improve and we do not.

If the UK economy is to flourish, an increase in the rate of growth, an improvement in productivity and a satisfactory agreement with the EU are all crucial.